Every year taxpayers are hit with tax surprises that could be avoided if they just knew the rules. Here are five big ones that are easy to avoid with some simple planning.
Mistake #1. Withholding too little. This results in a tax surprise when filing your income tax return. Don’t be too hard on yourself if this happens to you. Social Security withholdings change each year and not understanding how your employer calculates how much tax to withhold can also contribute to withholding too little.
The plan: Check your withholdings after filing each year’s tax return. Make adjustments as necessary by filing a new Form W-4 with your employer. This is especially important if you have received unemployment benefits or need to make estimated tax payments due to the recent pandemic.
Mistake #2. Inadvertently withdrawing funds from retirement plans. Amounts taken out of pre-tax retirement plans like 401(k)s and IRAs can create taxable income. The most common inadvertent withdrawal occurs when you roll over funds from one retirement plan to another. If done incorrectly, the entire rollover could be deemed taxable income.
The plan: Do not touch your retirement accounts if at all possible. (Exception: When you reach age 72, you may be subject to required minimum distribution rules.) If you do withdraw funds, ensure you have the proper withholdings taken out at the time of withdrawal. Direct rollovers into your new plan are always a better alternative than receiving the withdrawal from the plan administrator and then conducting the transfer yourself.
Mistake #3. Not taking advantage of tax-deferred retirement programs. There are numerous opportunities to shelter income from tax through tax-deferred retirement programs.
The plan: Review your retirement savings options and plan to contribute as much as possible to your plans. Pay special attention to plans that include an employee match component. This attention can reduce your taxable income each year.
Mistake #4. Direct deposit mix-ups. You may now have tax refunds directly deposited in up to three bank accounts. The problem: what if one of the account numbers is entered incorrectly? Unfortunately, unlike replacing a lost check, the IRS does not have a good means of correcting this type of error. There have been instances where taxpayers have lost their refund when this occurs.
The plan: Many taxpayers do not feel comfortable giving the IRS direct access to their bank account. If you are in this camp, the digital deposit problem is solved as you will receive a physical check for any overpayment. If you use direct deposit, avoid depositing your refund into more than one account. Ideally, have a second person double check the account number on your tax form prior to submitting the return.
Mistake #5. Not keeping correct documentation. You know you drove the miles, donated the items to charity, had the medical expense and paid the daycare. How can the IRS be disallowing your valid deductions? Remember that without correct documentation the IRS is quick to disallow them.
The plan: Set up good record keeping habits at the beginning of each year. Create both a digital and paper folder separated by income and expense type. Keep a contemporaneous mileage log and properly document your charitable contributions